Options traders are always on the lookout for an edge. Stocks do not trade precisely how they are expected to, meaning there is some variance around what a stock should be worth at any given time. It can be due to market psychology, company news, or even rumours. When options traders think about volatility, it is essential to understand what implied volatility means.
What does implied volatility mean?
Implied volatility is one of the most common factors affecting option prices. Professional traders have long known it as one of the critical components in predicting future changes in stock price movement.
Implied volatility considers all of the variables that affect the value of an option and expresses them as a percentage rate per year (annualised). It is calculated using Black-Scholes Option Pricing Model and is a figure that options traders use to determine the value of options. Generally speaking, implied volatility represents an opinion about future stock prices movements, which drives how much investors are willing to pay for options. You can argue that Implied Volatility holds more weight in determining the future price movement of an option rather than its statistical volatility.
Low vs high volatility
Stock prices constantly fluctuate hourly or daily, caused by various factors. These fluctuations cause options trading strategies to change over time, allowing traders to maximise their profits while minimising risk exposure by predicting changes in stock price based on data. A low degree of volatility means that the stock will not exhibit large swings in either direction, whereas high volatility means you can expect big moves up or down.
Other factors to consider include:
Implied volatility is not the only factor that options traders use to price options, but it is most important. Other factors considered include time until expiration, underlying security’s price, strike price, dividends, and interest rates. Collectively, all these factors form what is called an option’s ” Greeks .” Most professional traders use implied volatility to determine how much an option is worth and whether or not it is overpriced or underpriced.
Schools of thought
There are two schools of thought when trading with implied volatility. The first believes that implied volatility will revert to its mean, while the second assumes indicated volatility trends. Mean reversion traders believe that a stock’s historical volatility better indicates future volatility. In contrast, trend followers believe that the current implied volatility better predicts future stock price movement.
Implied volatility is beneficial for both professional traders and individual investors
Implied volatility is crucial for professional traders, but individual investors can also understand it. For example, say you consider buying a call option on a particular stock. Make sure that the implied volatility is high enough so that the option has enough time value remaining. This way, even if the stock does not move in your favour, you still have some time value remaining to make a profit. On the other hand, if you are short an option, you would want the implied volatility below so that the time value erosion works in your favour.
Implied volatility is an essential factor that options traders use to price options. It is a measure of future stock price movement and can predict changes in stock price. Implied volatility reflects the opinions of the market about future stock price movements and can be used to determine whether or not an option is overpriced or underpriced. It is also essential for individual investors because it can help you make better decisions when trading options.